Buffeted by geopolitical events in the Middle East, oil prices have been on quite a roller coaster ride this year. On Feb. 11, as the unrest in Libya began to play out, prices for crude hovered at $85 a barrel. By the end of April, they peaked at almost $114 a barrel, then hung around the mid-$90s through the end of July before sliding to $88 a barrel at the end of August.
Amid all the turmoil, oil prices are up from barely $20 a decade earlier, making it reasonable to assume that many energy companies are wallowing in cash - and that payouts to investors may be significant. Indeed, many clients probably hold shares of giants like ExxonMobil (now paying a 2.5% dividend) and Chevron (3.2%), through mutual funds or directly.
But other types of energy companies may deliver much more cash to yield-starved clients. In particular, master limited partnerships generally provide higher distributions. Despite some interest rate and tax risks for investors, these partnerships appear to be enjoying greater popularity, which has spawned many new ways to invest in these complex energy vehicles.
GO WITH THE FLOW
Like all limited partnerships, MLPs have a general partner who manages the enterprise, and limited partners who are typically passive investors. Such partnerships get the "master" label if they are publicly traded.
Under federal law, MLPs are limited to certain industries, including oil and natural gas. "For the most part, MLPs operate petroleum pipelines," says Abraham Bailin, an ETF analyst at Morningstar.
Some other MLPs are in various sectors of oil and natural gas processing, transportation or storage, which gives them a presence in the energy sector without direct exposure to price volatility. "MLPs may have a very stable revenue stream," Bailin says.
In addition, MLPs avoid paying tax at the entity level if they pass revenues to the limited partners. Consequently, cash flowing out to investors may be generous. "The average distribution to investors is now around 6%," says Mary Lyman, executive director of the National Association of Publicly Traded Partnerships.
RECOGNIZE THE RISKS
Of course, if a stable business pays out 6% to investors in an ultra-low-yield environment, there must be some risks. The biggest, says Ethan Bellamy, director and senior research analyst at Baird in Milwaukee, is a sharp increase in interest rates for "bad reasons."
"If Treasury yields escalate because of a lack of faith in the U.S. dollar, MLPs could trade at lower prices," he says. MLPs are fixed-income vehicles, to a certain extent, and rising interest rates tend to devalue bonds and bond proxies. But higher interest rates caused by stronger economic growth might not be as damaging to MLP prices, Bellamy says.
In essence, energy MLPs are stock-bond hybrids; they're high-payout entities that may benefit from increasing economic activity. Having one foot in the stock market, though, raises another obvious risk - they're vulnerable to stock market crises.
Many MLPs were hit hard by the 2008-09 crash, even though fundamentals remained solid. "Distributions went up, but prices went down," Bellamy explains.
Another risk is the potential revamp of the tax code. Even if MLPs escape the next tax overhaul wave, a constant stream of speculation could cause a sell-off of these relatively illiquid issues.
SEEK SHELTER
In the meantime, MLPs continue to offer tax advantages to investors. Generally, only about 15% to 25% of an MLP's distribution is taxable to investors, Lyman says. That means, for example, an investor who receives a 6% distribution of $100 might have to report only $20 of taxable income; the rest may be sheltered by non-cash deductions, such as depreciation.
In this hypothetical example, a top-bracket investor would owe only $7 to the IRS (35% of $20), and keep $93, for a net payout of 5.58%. The untaxed $80 would lower his or her basis and result in a higher tax bill on an eventual sale, according to Lyman.
The unique structure of MLPs raises some other concerns, however. Investors receive partnership K-1 tax documents, rather than 1099s. This may make tax preparation more complicated -and perhaps more expensive.
Also, some states are becoming more aggressive in taxing non-residents, Lyman reports. Thus, an investor in an MLP that operates a lengthy pipeline might have to file tax returns in several states. Lyman also notes that investors who hold MLPs in tax-exempt accounts, such as IRAs, may owe unrelated business income tax.
Nonetheless, "Investing in MLPs is still worth it," Lyman insists. Bellamy agrees such issues need not deter investors. Unrelated business income tax only becomes an issue if relatively large amounts are involved, he says, and state taxes also may be imposed only if MLP income reaches certain levels.
"As for complexity," says Bellamy, "TurboTax can handle the K-1 reporting. If you use a CPA who has trouble dealing with K-1s, you should get another CPA."
INVESTIGATE OPTIONS
Still, MLPs may be unfamiliar to many investors and difficult for financial planners to explain fully to clients. For such reasons, as well as for diversification and for easier 1099 reporting, MLP funds have emerged in recent years. Planners interested in this category but reluctant to make individual picks can now choose among mutual funds, closed-end funds, ETFs and exchange-traded notes.
For instance, Morningstar reports that nine closed-end funds have "MLP" in their name. (Other closed-end funds may hold MLPs, but with different names.)
The oldest of the nine (Kayne Anderson MLP and Fiduciary-Claymore MLP Opportunity) started in 2004; Kayne Anderson is the largest, with more than $2 billion in assets. Five of the other seven MLP closed-end funds launched in the past year and a half.
In late August, the Kayne Anderson MLP and the Fiduciary-Claymore MLP Opportunity Fund had five-year annualized returns of 8.9% and 8.5%, respectively. For both funds, yields were around 7%.
Illustrating the possible volatility, Kayne Anderson plunged nearly 40% in 2008, then gained almost 75% in 2009. The fund tracked the S&P 500 from inception in 2004 through 2008, but has far outpaced that benchmark since then. Fiduciary-Claymore has posted similar results. (Kayne Anderson Fund Advisors has several other closed-end funds that provide substantial current income with holdings that may include MLPs.)
In addition to multiple closed-end funds, investors seeking a mix of MLPs have other investment options. Morningstar lists eight ETNs with MLP in their name, all of which were launched in the last two and a half years (and mostly in 2010).
JPMorgan Alerian MLP Index ETN, the oldest, has $2.7 billion in assets, nearly 10 times the others combined. The Alerian Index tracks 50 companies mainly involved in pipelines and energy storage. The index has a current yield of 7%.
"An ETN is treated as debt," Bailin explains. It bears the credit risk of the issuer, such as JPMorgan Chase. This structure may offer several advantages over investments in individual MLPs, such as no tracking errors and no concerns about unrelated business income tax.
The lone ETF with MLP in its name, ALPS Alerian MLP ETF, has attracted more than $1.2 billion since an August 2010 launch. The partial tax shelter of MLP distributions is passed through. "ETFs might fit in a taxable account, while ETNs go into an IRA," Bailin says.
Morningstar also lists nine mutual funds with MLP in their names, all introduced in 2010 and 2011. The oldest and largest - SteelPath MLP Select 40 - had about $550 million in assets at the end of July, 16 months after inception. Some planners prefer mutual funds, which are not bound to an index, while others opt for exchange-traded products, which typically have lower expense ratios.
Because the ETNs, ETFs and mutual funds are so new, performance data is scant. But JPMorgan Alerian MLP Index ETN returned 34.53% in 2010, followed by a 3% total return in the first seven months of this year. SteelPath showed a 12-month return of 10% at the end of August. For all of these recent MLP entries, yields are around 5% to 6%.
POINTERS FOR PLANNERS
"MLPs have provided the opportunity for high, inflation-hedged, and in most cases, tax-sheltered income," says Steve Stahler, a planner in Baton Rouge, La., who's been using them and related investments since 2003. "The potential for the increase in dividends and the relative safety of the underlying assets has made this a favorite for retirees."
Stahler notes that pipelines get paid for the volume of the commodity that they carry, regardless of price, so they still work well for investors even at times when oil and gas prices are falling. Among the MLPs Stahler has purchased for clients are Linn Energy, Kinder Morgan, Energy Transfer Partners and Oneok Partners.
"I use individual MLPs in taxable accounts," Stahler says. "The K-1 headache is well worth the hassle if the client's tax scenario supports it." Stahler adds that the untaxed income from MLP distributions may actully help some retired clients reduce the tax they owe on Social Security benefits.
"We use the ALPS Alerian MLP ETF, the JPMorgan Alerian MLP Index ETN and the Fiduciary-Claymore MLP Opportunity Closed-End Fund to build a portfolio of MLPs in IRAs and qualified plans," he says. In some cases, "the tax consequences of the individual MLPs could bring taxation to an IRA," due to the unrelated business income tax. He adds that the choices for IRAs and qualified plans might vary depending on whether a closed-end fund can be bought at a discount.
James Shelton, chief investment officer at Kanaly Trust in Houston, says he saw MLP opportunities amid the financial crisis. "We invested there in late 2008 when yields reached double-digits for even the largest, most liquid and stable names," he says. "We've had excellent results, and each pullback has proved to be yet another good buying opportunity."
"We prefer the large pipeline operators," Shelton says, "due to stability of cash flow, lack of commodity price risks and the financial flexibility required to invest in the business." His current holdings include Enterprise Products Partners and Plains All American Pipeline, both of which are held in taxable accounts.
"The primary factor to consider in owning the individual MLPs is the tax reporting," Shelton says. "We typically own them only in taxable accounts where the client is comfortable with the tax reporting, including the K-1 and state tax issues."
For IRAs, Shelton prefers JPMorgan Alerian MLP Index ETN. "MLP mutual funds and ETNs are tax-inefficient in taxable accounts because the dividends are taxed as ordinary income," he says. "As a result, there can be a significant performance drag relative to individual MLPs in taxable accounts."
As long as MLPs are able to pay out a strong cash flow, new funds and trusts are bound to find their way to market. And planners may be able to direct clients toward investments with plump payouts that capitalize on gushing energy prices.
Donald Jay Korn is an editor at large of Financial Planning.
